text:
Children making ice cream to be sold for the benefit of the church at a meeting of ministers and deacons near Yanceyville, Caswell County, North Carolina
Ilargi: Right, enough with the Goldman Sachs bashing. When everyone form Krugman to Huffington to the Wall Street Journal editors get in one the action, it's time to step back, inhale, exhale and take another look. Sure, Goldman is a cabal bigger and more pernicious then the heads of all the Five Families, and without the code of honor to boot. They steal whatever they can, they cheat whoever they can and they'll lie to their wives ten times on monday mornings, before breakfast.
But that doesn't mean they are the major problem. Once again, we're getting it all wrong, in the same way we missed the mark complaining about $700 million in AIG bonuses against the backdrop of a thousand times that in Wall Street bailouts. Once you see what that adds up to, it's not wonder that furor died quietly in the night, is it?
Goldman Sachs can only get away with stealing, cheating and lying if they're allowed to do so. There is a very obvious first line of defense against such actions, which should for all intents and purposes be illegal, and where they're not yet, be made so yesterday. You all know who's in that defensive line. You pay them. It's what you call your government.
If your government stubbornly and steadfastly refuses to -in order to stop the cheating and lying- apply the laws where they're applicable, and change them where they need change, why would you expect Goldman to stop engaging in their favorite pastimes? Wouldn't you agree that that is not wholly and entirely the smartest assumption to make?
It's not Goldman that fails. Goldman even does what it is by law required to do: maximize the returns for its shareholders. If it wouldn't, its directors could be sued.
It's not Goldman, it's the government that fails. The government looks after Goldman's interests, bails them out with dozens of billions of dollars, most of which are never repaid, looks the other way when laws are broken, won't change those laws that fail to protect the public etc. The list of where and when the government fails to protect the people who voted it in is so long, and so deep, that if we would take an afternoon to try and list all applicable points, we would by the end want to crawl into a deep dark corner in order to hide the deep dark red color of our cheeks.
And I think that is why we won't make that list, of how our governments fail us. We intuitively know where that would inevitably lead. That is, our own shame.
Because we all know very well who put that government there, the Obama's, the Geithners, Barney Franks, Chris Dodds and Nancy Pelosi's.
Blaming Goldman Sachs for your problems and your anger is nothing but a cheap diversion. Who did you vote for, and if it was the Democrats, what are they doing with their new found power? How is today different from 6 or 4 or 2 years ago? How different? Do you still believe in that change, or is it time to change your beliefs?
Whatever you do, don't blame Goldman. Don't even blame Obama.
Blame yourself. In the end, that's the only way you can keep a grip on power. And on your life.
Ilargi: Barry Ritholtz got this one nailed. I saw a headline today that he doesn't yet mention: "Housing starts highest in 7 months". Yeah, right,
US Housing Starts Fall 46%
by Barry Ritholtz
Yet another set of odd and misleading coverage on Housing Starts.BUILDING PERMITS: Privately-owned housing units authorized by building permits in June were at a seasonally adjusted annual rate of 563,000. This is 8.7% (±3.0%) above (revised) May rate, but is 52.0% (±3.6%) below the June 2008.
HOUSING STARTS: Privately-owned housing starts in June were at a seasonally adjusted annual rate of 582,000. This is 3.6% (±11.3%)* above the revised May estimate but is 46.0% (±4.3%) below the June 2008.
What can we tell from this data?
Nothing about monthly change in Starts (data points less than the margin of error are not statistically significant); We can say that permits were up month to month, although how much of that is seasonal is hard to decipher.
The year-over-year data is much clearer: New Starts down 46%, Permits down 52%.
Not exactly green shoot materials here — but given the enormous inventory overhang, less new building is better. And since year-over-year compares the same month, seasonality is not a factor.
Incidentally, much of the media reportage on this was simply innumerate — the numerical equivalent of illiteracy. Not just a little wrong, but totally, embarrassingly incorrect.
WSJ: "Housing starts increased 3.6% to a seasonally adjusted 582,000 annual rate compared to the prior month, the Commerce Department said Friday."
Bloomberg: Housing starts in the U.S. unexpectedly rose in June as construction of single-family dwellings jumped by the most since 2004, signaling the market is stabilizing. The 3.6 percent increase brought starts to an annual rate of 582,000.
Marketwatch: Housing starts rose 3.6% to a seasonally adjusted annual rate of 582,000, the highest figure November.
Reuters: New housing starts and permits jumped more than expected in June, propelled by a rise in single-family homes, a government report showed on Friday. Housing starts climbed 3.6 percent to seasonally adjusted annual rate of 582,000 units, from May's upwardly revised 562,000 units, the Commerce Department said.
No, that is not what they said at all – plus 3.6% with a margin of error of 11.3% = YOU DON"T KNOW.
I know, this is a pet peeve of mine — but still, it makes you wonder if these people can count to 21 unless they are naked.
Note the number of monthly improvements which did not prevent big annual drops over the past 3 years:
graph courtesy of Barron's Econoday
Michigan Jobless Rate Tops 15%, California Sees Record Level
Six U.S. states posted record unemployment rates in June, while Michigan became the first to top 15 percent in a quarter century, threatening to deepen budget crises in capitals across the nation. The total number of states with at least 10 percent joblessness rose to 15, the Labor Department reported today in Washington. Georgia, Nevada, Rhode Island, South Carolina, Florida and Delaware all reached their highest level of joblessness since records began in 1976.
Today's figures are a blow to states already hammered by falling income and sales-tax receipts. California suffered the biggest drop in payrolls among all states, at a time when its lawmakers are struggling to narrow a $26 billion budget gap that may send its debt rating below investment grade. "It'll easily be mid-2010 before we see unemployment rates leveling off," said Steven Cochrane, director of regional economics at Moody's Economy.com in West Chester, Pennsylvania. Should the labor market fail to recover before the Obama administration's $787 billion stimulus spending runs out, "states will face more problems," he said, as they struggle with lower tax revenue and higher spending on jobless benefits.
California's jobless rate held at a record 11.6 percent for a second month, after May's level was revised from a previously reported 11.5 percent. Unemployment in the District of Columbia exceeded 10 percent for a second month, rising to 10.9 percent. Florida's unemployment rate climbed to 10.6 percent as job losses that began in the construction industry spread. Unemployment in Georgia, the ninth-largest U.S. state by population, exceeded 10 percent for the first time ever, increasing to 10.1 percent last month from 9.6 in May. Alabama's jobless rate also crossed that threshold, jumping to 10.1 percent from 9.8 percent.
Employers across the U.S. are trimming positions and delaying hiring even as reports show housing and manufacturing are stabilizing. The economy has lost about 6.5 million jobs since the recession began in December 2007. President Barack Obama and economists surveyed by Bloomberg News say national unemployment will reach 10 percent this year. "No region of the U.S. is immune," said Rebecca Braeu, an economist at John Hancock Financial Services in Boston. "The rising unemployment rate is clearly going to hurt consumption. It'll limit the recovery."
Payrolls in the world's largest economy fell by 467,000 last month, more than forecast, while the jobless rate jumped to 9.5 percent, the highest level in 26 years. The rate will reach 10 percent by yearend and average 9.8 percent for 2010, according to the Bloomberg survey. Michigan, the heart of the U.S. auto industry, jumped to 15.2 percent from May's 14.1 percent. General Motors Co. and Chrysler Group LLC have emerged from bankruptcy, and economists predict the slump in auto production may ease as government efforts to stoke consumer spending, including cash payments aimed at reviving car sales, take hold.
Financial firms continue to bleed jobs. New York City's unemployment rate jumped to 9.5 percent in June, the highest level since 1997, while the state jobless rate rose to 8.7 percent from 8.2 percent in May, figures showed yesterday. New Jersey's rate increased to 9.2 percent in June from 8.8 percent, while unemployment in Connecticut held at 8 percent. Improving home sales and smaller declines in manufacturing have caused economists to raise projections for growth. Growth will average 1.5 percent in the July-to-December period, helped by stabilization in consumer spending, which accounts for about 70 percent of the economy, the Bloomberg survey showed.
Even so, Americans without jobs aren't optimistic. "I don't think the economy is turning around," said Gary Lucas, 32, of Atlanta, who was laid off six months ago from a job installing fire-protection sprinklers in buildings. "I don't see it yet." Lucas said he has put out more than 30 applications with only a few expressions of interest.
Amanda Wright, a certified nurse's assistant, said she's been searching for work since 2007, "but nobody is biting." Wright, 22, was unable to get enough financial aid to complete a course in nursing radiology when she returned to school this year, and is tapping her savings and using discounts she gets through her mother's government job to put her one-year-old son in daycare. "I've registered with all the unemployment offices and temp agencies, but nobody calls," said Wright, who also has certifications in customer service and data entry and is looking for jobs in Alabama and elsewhere in Georgia. "The most frustrating part is sitting by the phone, the waiting."
The Solution is the Problem
by Eric Sprott & David Franklin
The US government raised $705 billion worth of new debt in 2008. The debt was raised to pay for a $455 billion budget deficit and $250 billion in "supplemental appropriations" for the wars in Iraq and Afghanistan. In 2009, the US government will (and must) sell $2.041 trillion in new debt. This debt will pay for a projected budget deficit of $1.845 trillion, supplemental appropriations of $196 billion for Iraq and Afghanistan, a fund for pandemic flu response and a line of credit to the IMF. In fiscal 2009, the United States must find buyers for almost three times the debt that was issued last year. Table A presents the ownership breakdown of current outstanding US debt as of September 2008. Each of the debt buyers presented will have to buy three times the debt that they bought last year, by September 2009, in order to balance the accounts of the United States Government.
Given the current state of the economy, it seems frighteningly apparent that a threefold increase in debt purchases by the account holders listed above is a mathematical impossibility. There is simply not enough money in the present economy to support a tripling bond issue in the normal course of business. To confirm this, we have grouped together similar debt holders in order to assess their potential buying capability for fiscal 2009, which ends on September 30th.
We begin with the largest buyers of debt outside of the United States 'Foreign and International Holders' (#2). This group accounts for the largest source of external capital for US debt purchases and represents a very important group to float the deficit. They collectively purchased $564 billion last year, and the US will require them to increase their purchases to $1.6 trillion in 2009. Thus far, they have only purchased $465 billion to March 2009, which is halfway through US fiscal year - and well behind the pace needed to triple last year's purchases.
Current data does not bode well for further purchases either. In fact, April Treasury data revealed that 'Foreign and International Holders' were net sellers of US debt from March to April 2009.4 This is not surprising given the public comments from officials in China, Japan, Russia and Brazil concerning the level of debt issuance by the United States and its potential impact on the US dollar.
Next we assess the pension funds. We combine 'Pension Funds - State and Local Governments' (#9) and 'Pension Funds - Private' (#7), as they both purchase US debt for similar purposes. Last year they collectively purchased a combined total of $52.6 billion of US debt, and under our tripling scenario they must purchase over $150 billion worth of US debt this year. As at the end of December 2008, the last date for which we have data, records show that they have purchased a mere $8.5 billion - so they have a long way to go. In fact, the Canada Pension Plan Investment Board recently stated that "it would be dangerous to increase the fixed-income portion of our portfolio at this point." 5 If the Canada Pension Plan is any indication, it is unlikely this group will carry their weight in fiscal 2009. Next, we group together 'Depository Institutions' (#10) and 'Insurance Companies' (#11).
Together they have been net sellers of US debt so far this fiscal year, selling a combined total of $20 billion in US bonds. As a group they made no new net purchases last fiscal year, and were sellers of debt as of the first quarter of this fiscal year. This should come as no surprise, as these institutions have had to deleverage their balance sheets to survive the financial crisis of 2008 and the devastating economic climate of 2009. The US Government will not be able to raise new funds from them, so we can cross them off our list.
Next, we examine 'State and Local Governments' (#4). As you have probably already heard, the majority of State governments are in serious financial trouble. The latest estimates show income tax revenues down a whopping 26% from last year.6 The State of California, which represents the 10th largest economy in the world, is currently on the verge of collapse from economic stress. Seeing as how they were net sellers of US debt last year, we will assume, given their difficulties, that they will be net sellers this year as well - so no help here.
'Mutual Funds', #3 on our list, drove a surge in debt purchases last year as the financial collapse took hold. They purchased $311 billion in 2008, so the US needs them to purchase close to a trillion this year. How are they doing thus far in 2009? A paltry $151 billion as at the end of December - and current data doesn't look promising for further purchases. Assets in money markets funds fell by $72.85 billion over the past week alone, including a large portion of which was comprised of US debt.7 We can safely assume that 'Mutual Funds' will fall short of their one trillion dollar quota for fiscal 2009.
'US Savings Bonds' (#8), which represents US domestic buyers of government debt, were net sellers in 2008 and net sellers again in 2009. This is no surprise to us given the state of the economy. There are no buyers in this category.
'Other Investors', #6 on our list, is a catch-all category. It includes individuals, government- sponsored enterprises, brokers and dealers, bank personal trusts and estates, corporate and non-corporate businesses and other investors. They collectively purchased $141 billion last year, and have currently purchased $158 billion to December 2008. As a group they are on track to purchase over $600 billion in debt this fiscal year. They are the only group realistically capable of tripling the purchases they made last year.
We have shown that the majority of traditional buyers of US debt will be unable to increase their debt purchases this year, so we must question how the United States is going to cover this colossal shortfall. Is there anyone else who can buy the required US debt in 2009? Surely the US Government can find someone willing to increase their debt holdings. It may not surprise you to learn that the largest percentage owner of US debt is the United States Government itself. Perhaps this doesn't make immediate sense to some readers, but it is a fact. The debt holdings are held in accounts for the various trust funds the US manages for its future obligations - the largest of which are set aside for Social Security and Medicare. These trust funds are lumped together and referred to as "Intragovernmental Holdings".
The only 'assets' held by these 'trust funds', however, are special-issue Treasury Bonds. Why? Because the US Treasury takes the Social Security and Medicare payroll taxes and uses these funds to pay for anything from aircraft carriers to education to welfare. To cover this drawdown, special-issue Treasury Bonds are deposited into the trust funds for Social Security and Medicare as IOU's. When the government issues a bond to one of its own accounts, it hasn't established a claim against another entity or person.
It is simply creating a form of IOU from one of its accounts to another. Put simply, there are no real economic assets that can be drawn down in the future to fund benefits. Instead, they are claims on the Treasury, that, when redeemed, will have to be financed by raising taxes, increasing borrowing or reducing expenditures. For all intents and purposes, Social Security and Medicare receipts are essentially considered to be another source of government tax revenue that can be spent each year.
In 2008, the Treasury Department issued the "Intragovernmental Holdings" account $254 billion in bonds (IOU's), and in the first half of fiscal 2009 this account actually became a net seller of bonds. Because the account is not broken down by individual trust fund, it is difficult to see which specific trust fund liquidated their bonds, but we suspect it was Medicare. The benefits currently being paid out of Medicare are already running higher than its inflows, so the difference must have been made up by sales of its IOU bonds.
Obviously this is a very troubling development for the US, and unfortunately it is likely to get worse. This year's Social Security fund is only expected to balance, which is bad news for the government. Along with Social Security, Medicare is one of the trust funds that should be posting surpluses right now in anticipation of the massive future commitments the retiring Baby Boomers will require. As it stands, Medicare is in an operating deficit in 2009 with premiums coming in at $14 billion and outlays totaling $348 billion.8 The difference will be supplemented by sales of its IOU bonds, which will ultimately add to the amount of new government debt that must be sold in fiscal 2009. We won't speculate on what would happen to the Social Security program if new buyers for US debt disappeared, but we should all bear in mind that in that scenario the special-issue 'IOU's' in the "Intragovernmental Holdings" account would be rendered worthless, and the US Government's social 'safety net' would vanish.
This net selling by US Government trust funds adds to the total amount of debt that needs to be marketed, so instead of facing a $2 trillion debt marketing problem in 2009, the US now has a debt marketing problem that is well in excess of $2 trillion. So, after all this, it should be clear by now as to who is going to cover the difference this fiscal year. As the lender of last resort, the only purchaser left is the Federal Reserve. In 2008 they were net sellers of almost $300 billion of bonds, but in the first half of this fiscal year they have been buyers of almost $280 billion of bonds. The Federal Reserve is the lender of last resort and must support the market for US debt. The policy 'solution' that the Federal Reserve implemented in March 2009 is called 'Quantitative Easing'. Given our projections above, this was not an option for them, but a necessity.
Quantitative Easing was pioneered by the Japanese in the early 2000's. It is an extreme form of monetary policy used to stimulate the economy when interest rates are at or close to zero. In practical terms, the Federal Reserve purchases assets, including treasuries and corporate bonds, from financial institutions using newly created money. The Federal Reserve typically controls the 'cost' of money with interest rates, but since interest rates can't be negative, the Federal Reserve now manipulates the quantity of money itself by printing more of it. The official announcement proclaiming this practice was made in March of this year, and it was hailed as a new stimulative mechanism to kick start the economy.
The Federal Reserve's 'solution' to the debt problem is the problem. It has resulted in the Federal Reserve doubling the monetary base of the United States over the span of a mere nine months. Rather than stimulate the real economy, the QE program has instead resulted in increasing weakness in the international market for US bonds - the proof of which can be seen in the chart below. Bond investors are running for the exits, and our discussion above confirms what we see in this chart. Traditional buyers of US bonds are now sellers, and they are exercising a non-confidence vote in the US dollar and in US debt.
As we hope the breakdown above has revealed, the future solvency of the United States as a nation state is currently in jeopardy. It is in far deeper trouble than the mainstream press cares to admit. There are simply not enough new buyers of debt on this planet to support the spending programs of the United States government - and it appears that current holders ofdebt are beginning to sell. Because it is impossible to balance the budget from outside sources of capital, the only source of funds left for the US, in all reality, is continued money printing.
The Federal Reserve's policy of Quantitative Easing is failing. The US budget is ludicrous, spending is out of control, spending promises are out of control, the world knows it - and we know it. For all the pundits who see the economy improving over the next year, we invite you to explain to us how this debt crisis will resolve itself without significant turmoil. We've tabulated the numbers above - and they do not lie. As we wrote this past January, welcome to 2009.
Federal Spending Will Make Us Go Broke
by Douglas Elmendorf , Director, Congressional Budget Office
Today I had the opportunity to testify before the Senate Budget Committee about CBO's most recent analysis of the long-term budget outlook.Under current law, the federal budget is on an unsustainable path, because federal debt will continue to grow much faster than the economy over the long run. Although great uncertainty surrounds long-term fiscal projections, rising costs for health care and the aging of the population will cause federal spending to increase rapidly under any plausible scenario for current law. Unless revenues increase just as rapidly, the rise in spending will produce growing budget deficits. Large budget deficits would reduce national saving, leading to more borrowing from abroad and less domestic investment, which in turn would depress economic growth in the United States. Over time, accumulating debt would cause substantial harm to the economy. The following chart shows our projection of federal debt relative to GDP under the two scenarios we modeled.
Federal Debt Held by the Public Under CBO's Long-Term Budget Scenarios (Percentage of GDP)
Keeping deficits and debt from reaching these levels would require increasing revenues significantly as a share of GDP, decreasing projected spending sharply, or some combination of the two.
Measured relative to GDP, almost all of the projected growth in federal spending other than interest payments on the debt stems from the three largest entitlement programs—Medicare, Medicaid, and Social Security. For decades, spending on Medicare and Medicaid has been growing faster than the economy. CBO projects that if current laws do not change, federal spending on Medicare and Medicaid combined will grow from roughly 5 percent of GDP today to almost 10 percent by 2035. By 2080, the government would be spending almost as much, as a share of the economy, on just its two major health care programs as it has spent on all of its programs and services in recent years.
In CBO's estimates, the increase in spending for Medicare and Medicaid will account for 80 percent of spending increases for the three entitlement programs between now and 2035 and 90 percent of spending growth between now and 2080. Thus, reducing overall government spending relative to what would occur under current fiscal policy would require fundamental changes in the trajectory of federal health spending. Slowing the growth rate of outlays for Medicare and Medicaid is the central long-term challenge for fiscal policy.
Under current law, spending on Social Security is also projected to rise over time as a share of GDP, but much less sharply. CBO projects that Social Security spending will increase from less than 5 percent of GDP today to about 6 percent in 2035 and then roughly stabilize at that level. Meanwhile, as depicted below, government spending on all activities other than Medicare, Medicaid, Social Security, and interest on federal debt—a broad category that includes national defense and a wide variety of domestic programs—is projected to decline or stay roughly stable as a share of GDP in future decades.
Spending Other Than That for Medicare, Medicaid, Social Security, and Net Interest, 1962 to 2080 (Percentage of GDP)
Federal spending on Medicare, Medicaid, and Social Security will grow relative to the economy both because health care spending per beneficiary is projected to increase and because the population is aging. As shown in the figure below, between now and 2035, aging is projected to make the larger contribution to the growth of spending for those three programs as a share of GDP. After 2035, continued increases in health care spending per beneficiary are projected to dominate the growth in spending for the three programs.
Factors Explaining Future Federal Spending on Medicare, Medicaid, and Social Security (Percentage of GDP)
The current recession and policy responses have little effect on long-term projections of noninterest spending and revenues. But CBO estimates that in fiscal years 2009 and 2010, the federal government will record its largest budget deficits as a share of GDP since shortly after World War II. As a result of those deficits, federal debt held by the public will soar from 41 percent of GDP at the end of fiscal year 2008 to 60 percent at the end of fiscal year 2010. This higher debt results in permanently higher spending to pay interest on that debt. Federal interest payments already amount to more than 1 percent of GDP; unless current law changes, that share would rise to 2.5 percent by 2020.
Two Giants Emerge From Wall Street Ruins
A new order is emerging on Wall Street after the worst crisis since the Great Depression — one in which just a couple of victors are starting to tower over the handful of financial titans that used to dominate the industry. On Thursday, JPMorgan Chase became the latest big bank to announce stellar second-quarter earnings. Its $2.7 billion profit, after record gains for Goldman Sachs, underscores how the government's effort to halt a collapse has also set the stage for a narrowing concentration of financial power.
"One theme here is that Goldman Sachs and JPMorgan really have emerged as the winners, as the last of the survivors," said Robert Reich, a professor at the University of California, Berkeley, who was secretary of labor in the Clinton administration. Both banks now stand astride post-bailout Wall Street, having benefited from billions of dollars in taxpayer support and cheap government financing to climb over banks that continue to struggle. They are capitalizing on the turmoil in financial markets and their rivals' weakness to pull in billions in trading profits.
For the most part, the worst of the financial crisis seems to be over. Yet other large banks, including Citigroup and Bank of America, are still struggling to return to health. Both are expected to report a more profitable quarter on Friday, but a spate of management changes and looming losses from credit cards and commercial real estate have thwarted a stronger recovery. And then there are the legions of regional and small banks that are falling in greater numbers across the country. While many have racked up large losses, they stand to bleed more red ink if the recession wears on. Fifty-three have failed this year, and the Federal Deposit Insurance Corporation is girding for scores to follow.
Uncertainties over the economy mean that Goldman and JPMorgan may be enjoying a fragile dominance, industry experts said. JPMorgan reported big declines in its consumer business on Thursday, and it has set aside more than $30 billion to cover future losses from surging credit card charge-offs and mortgage and home equity losses. "Nobody is through this until unemployment turns around," said Moshe Orenbuch, a Credit Suisse banking analyst.
And if regulation being considered in Washington is passed, banks would face new limits on the amount of their own capital they may trade. That could limit the profits that banks like Goldman and JPMorgan make from their trading businesses, and level the playing field, experts say. Other former Wall Street stars like Morgan Stanley, which was hurt more by the crisis and has avoided taking big risks in the new era, may also rebound and begin to take on old rivals.
But for now, Goldman Sachs and JPMorgan are surging. "The stronger players are positioned to take advantage of the crisis and they will dominate clearly in the near term," said James Reichbach, the head of Deloitte's United States financial practice. JPMorgan's renewed strength, like Goldman's, comes as it vaults ahead of longtime rivals, especially in investment banking, including bond and equity trading, and underwriting debt to help companies issue shares and bonds. Traders took advantage of big market swings and less competition to post big gains in fixed-income and equities.
Michael J. Cavanagh, the chief financial officer at JPMorgan, said its profit and fees from this business were "a record for us in a quarter and a record for anybody at any firm in any quarter." The bank, he added, was "so very proud of those results." It has also profited from the demise of weaker banks to enlarge its market share in mortgages and retail banking. On Tuesday, as the CIT Group, a lender to many small businesses, negotiated with the government to avoid collapse, JPMorgan signaled that it was watching.
"It would be an opportunity for us in these states if CIT was unable to continue lending to borrowers," Tom Kelly, a spokesman at Chase, was quoted by Dow Jones Newswires as saying. And revenue from the retail bank Washington Mutual, which JPMorgan acquired last fall, is starting to help earnings. Morgan is also profiting from its government-assisted purchase of Bear Stearns last year. JPMorgan is now No. 1 globally in equity and debt capital markets, according to Dealogic.
Amid the surge, Jamie Dimon, JPMorgan's chief executive, has cemented his status as one of America's most powerful and outspoken bankers. He has vocally distanced himself from the government's financial support, calling the $25 billion in taxpayer money the bank received in December a "scarlet letter" and pushing with Goldman Sachs, Morgan Stanley and others to repay the money swiftly. Those three banks repaid the money last month.
Yet JPMorgan's transformation into one of the industry's strongest players is underpinned by the shelter it received from the government: The bank used the money as a cushion until it was able to raise new capital. "There is no doubt all of us benefited from the government help — all of us," said a senior executive at another Wall Street bank. A spokesman for JPMorgan said the bank accepted aid at the request of the government but would not comment beyond that. Few banks have undergone such a turnaround. Only a few years ago, JPMorgan was struggling after years of poor management and a failure to digest a series of big acquisitions. But under Mr. Dimon, it cut costs and strengthened its balance sheet.
The payoff began last year. With the industry teetering on the verge of collapse, JPMorgan snapped up Bear Stearns in March 2008 and Washington Mutual last fall in two government-assisted transactions. Clients say that its growing dominance has given it more leverage to charge for lending and other services. After aggressively lobbying to repay its taxpayer money, Mr. Dimon has also been driving a hard bargain over the repurchase of warrants the government received from the bank last autumn in exchange for taxpayer support.
JPMorgan is now planning to let the Treasury Department auction off the warrants to private investors after the two sides failed to agree on a price. Mr. Dimon is also gearing up for a series of battles in Washington. One is over tighter regulations for derivatives, a business where the bank generates lucrative fees as one of the industry's largest players. Another is the creation of a new consumer protection agency, which could threaten the profitability of the bank's mortgage and credit card businesses if it introduces tougher regulations. JPMorgan's stock has risen 20 percent since early March. It closed Thursday at $35.76.
AIG's European Derivatives May Take Decades to Expire
American International Group Inc.'s trading partners may force the insurer to bear the risk of losses on corporate loans and mortgages for years beyond the company's expectations, complicating U.S. efforts to stabilize the firm, analysts said. European banks including Societe Generale SA and BNP Paribas SA hold almost $200 billion in guarantees sold by New York-based AIG allowing the lenders to reduce the capital required for loss reserves. The firms may keep the contracts to hedge against declining assets rather than canceling them as AIG said it expects the banks to do, according to David Havens, managing director at investment bank Hexagon Securities LLC.
"For counterparties to voluntarily terminate those contracts makes no sense," Havens said in an interview. "There's no question that asset values have soured on a global basis. With the faith and credit of the U.S. government backing those guarantees, why would they give that up?" The falling value of holdings backed by the swaps may force AIG to post more collateral, pressuring the insurer's liquidity and credit ratings in a repeat of the cycle that caused the firm's near collapse in September, Citigroup Inc. analyst Joshua Shanker said last week. The insurer needed a U.S. bailout valued at $182.5 billion after handing over collateral on a different book of swaps backing U.S. subprime mortgages.
The average weighted length of the European swaps protecting residential loans is more than 25 years, while the span tied to corporate loans is about 6 years, AIG said in a regulatory filing. Contracts covering corporate loans in the Netherlands extend almost 45 years, and the swaps on mortgages in Denmark, France and Germany mature in more than 30 years. The portfolio shrank by about half in 15 months to $192.6 billion on March 31 and AIG's models show banks will abandon more contracts, said Mark Herr, a spokesman for the insurer. AIG said in a filing last month it expects the banks to cancel "the vast majority" of the contracts in the next year as regulatory changes reduce the benefits of the derivatives for lenders.
"We think we're right because we're basing our analysis on actual behavior," said Herr. "The inarguable fact is that half of the portfolio had been unwound at no cost to us as of March 31." The contention that the swaps will last beyond a year is a "theoretical argument that is debunked" by banks' actions, he said. Last month, AIG said in a regulatory filing that it may be at risk for losses for "significantly longer than anticipated" if the banks don't terminate their swaps. "Given the size of the credit exposure, a decline in the fair value of this portfolio could have a material adverse effect on AIG's consolidated results," the company said in the June 29 filing.
The Securities and Exchange Commission asked for AIG to add the disclosure to the insurer's "risk factors," Herr said. The action wasn't prompted by any change in the securities backed by the swaps, he said. Royal Bank of Scotland Group Plc, Banco Santander SA, Danske Bank A/S, Rabobank Group NV and Credit Agricole SA's Calyon are also among banks which purchased the swaps, AIG said in a presentation in February pleading for its latest bailout. The banks could be forced to raise $10 billion in capital if AIG were allowed to fail, according to the document.
Santander said through a spokesperson that the bank's risk of an AIG failure is insignificant and fully collateralized. Calyon declined to comment. Representatives of the other lenders didn't immediately return messages seeking comment. Counterparties terminated or allowed to expire $27.8 billion in the so-called regulatory relief swaps in the first quarter, and AIG got notice for another $16.6 billion in terminations through April 30, the firm said. Some of the remaining swaps have suffered losses, and AIG posted $1.2 billion in collateral as of the first quarter.
"You'll have an increasingly toxic pool of credit-default swaps every quarter" as the least risky swaps are terminated, said Donn Vickrey, analyst at research firm Gradient Analytics Inc. "Swaps that are being held are done so for two reasons, either for regulatory relief or because they're 'in the money'" which means they are valuable hedges against asset declines. AIG has recognized that some of the swaps are no longer being held for regulatory relief. The insurer reclassified $3 billion in swaps through March 31 that are likely to be kept after the regulatory benefit expires, AIG said. The firm had a $393 million liability on those swaps.
Gerry Pasciucco, hired in November to clean up the Financial Products unit that sold the swaps, said in an interview in December that the European swaps would mature over time without loss and faced very little risk. Pasciucco said in April that future losses will be limited. The $192.6 billion figure for the swaps includes $99.4 billion tied to corporate loans and $90.2 billion linked to prime residential mortgages, the insurer said.
"The sheer size of the portfolio and the 'black box' nature of its underlying loans and assets do little to calm fears of further CDS losses," Shanker said in the July 8 research note. "Potential markdowns in the regulatory CDS portfolio may result in collateral calls that would again put pressure on AIG's liquidity." The government's rescue includes a $60 billion credit line, $52.5 billion to buy mortgage-linked assets owned or insured by the company, and an investment of as much as $70 billion. AIG plans to reduce its debt under the credit line by $25 billion by handing over stakes in two non-U.S. life insurance units, the insurer said last month. AIG has tapped about $43 billion from the line as of July 15.
Paulson reveals US concerns of breakdown in law and order
The Bush administration and Congress discussed the possibility of a breakdown in law and order and the logistics of feeding US citizens if commerce and banking collapsed as a result of last autumn's financial panic, it was disclosed yesterday. Making his first appearance on Capitol Hill since leaving office, the former Treasury secretary Hank Paulson said it was important at the time not to reveal the extent of officials' concerns, for fear it would "terrify the American people and lead to an even bigger problem".
Mr Paulson testified to the House Oversight Committee on the Bush administration's unpopular $700bn (£426bn) bailout of Wall Street, which was triggered by the failure of Lehman Brothers last September. In the days that followed, a run on some of the safest investment vehicles in the financial markets threatened to make it impossible for people to access their savings. Paul Kanjorski, a Pennsylvania Democrat, asked Mr Paulson to reveal details of officials' concerns, which were relayed to Congress in hasty conference calls last year. The calls included discussion of law and order and whether it would be possible to feed the American people, and for how long, according to Mr Kanjorski.
"In a world where information can flow, money can move with the speed of light electronically, I looked at the ripple effect, and looked at when a financial system fails, a whole country's economic system can fail," Mr Paulson said. "I believe we could have gone back to the sorts of situations we saw in the Depression. I try not to use hyperbole. It's impossible to prove now since it didn't happen."
The Oversight committee is investigating the takeover of Merrill Lynch by Bank of America, a deal forged in the desperate weekend that Lehman Brothers failed, and which later required government support because of Merrill's spiralling losses. Mr Paulson defended putting pressure on Bank of America when it had last-minute doubts about the deal in December. Not to have done so could have rekindled the "financial havoc" the bailout had calmed.
Hank Paulson Fleeced the American Taxpayers in Order to Save Them
Hank Paulson is deeply empathetic about the American people's plight; absorbing intergenerational levels of debt to cover the costs of unbridled greed and recklessness on the part of Wall Street. Thus, while being raked over the coals at a congressional hearing for his role in the near destruction of the global financial system last fall, and the $700 billion TARP Wall Street bailout package he was able to pull through a terrified Congress as the price of avoiding financial Armageddon, the former Treasury Secretary had this to say about the plight of the American people: "The tragedy is they didn't create the problem. But they would be the ones that would pay the greatest penalty if there was a collapse."
Paulson's statement, while superficially sympathetic to the injustice of the collective innocent paying for the sins of the few, is in substance the manifestation of a disdain for the broad masses that borders on contempt. In effect, he is reiterating a posture that has been consistently maintained by the "masters of the universe" since the onset of the global financial and economic crisis; privatize the profits (especially after radical deregulation) but socialize all losses.
Since last fall, trillions of dollars have been added to the U.S. national debt through TARP, fiscal stimulus packages made necessary by the financial collapse, and other forms of direct and indirect government and Federal Reserve aid to the financial sector. All in the name, we are told, of the American people who, it is claimed, would be subjected to even greater debt and future taxation if Wall Street is not bailed out. The old concept of "moral hazard," still in force when Paulson allowed Lehman Brothers, a competitor of his former stomping ground Goldman Sachs to die, was swiftly ejected when AIG faced bankruptcy.
Now Goldman Sachs is declaring a record quarterly profit, and arrogantly boasting of the billions of dollars of bonus payments that will be dished out to its employees. What the firm that Paulson used to lead as Chairman won't divulge is how much of its profit was due to $13 billion it received in payment from the U.S. taxpayer, using AIG as a pass-through for the payment. Neither will this Wall Street entity make public the impact of tens of billions of dollars in low-interest, taxpayer subsidized loans it now has access to, once Hank Paulson and Fed Chairman Ben Bernanke changed the rules, and allowed investment banks such as Goldman Sachs to magically transform themselves into bank holding companies.
If Hank Paulson symbolizes the incestuous relationship between Wall Street and government, his attitude reflects how insignificant the general public has become in the minds of those calling the shots and making the critical policy decisions in the wake of the worst economic crisis to afflict the American people since the Great Depression. But when those who caused the disaster are spared the ravages of the unwashed masses who are now being corralled into ever-growing unemployment lines, and instead are basking in the illumination of near record bonus payments, their callousness can at least be understood.
The question that Hank Paulson and his ilk may ultimately be compelled to answer is why should the American people be eternally grateful for their "noblesse oblige" when it becomes crystal clear to them that they have been dispossessed of much of their future as the price for bailing out Wall Street and its architects of our current economic and financial doom.
Shattering the Right vs. Left Prism Once Again: The Wall Street Journal Goes After Goldman and the Bank Bailout
Yesterday's opinion section of the Wall Street Journal offered convincing proof that those who want a progressive financial policy and those who simply want to save capitalism are in agreement about the madness of the administration's Wall Street policies. There, on the editorial page of the capitalist Bible, was a piece taking repeated shots at Wall Street darling Goldman Sachs. And, over on the opposite page, a two-fisted op-ed by former hedge-fund manager Andy Kessler in which he labels the government bailout of Wall Street "a dumb move" and "a bust."
I'm planning to shrink down today's Journal, laminate it, and hand it out anytime someone in the media starts analyzing the economy using the cobweb-covered, tried-and-untrue right vs. left framing. You know that this way of looking at financial policy is dead and buried when Rupert Murdoch's pride and joy is publishing takes that I could happily have written myself. Let's start with the editorial, "A Tale of Two Bailouts," which decries the fact that, thanks to the policies of Tim Geithner and Larry Summers, Goldman "enjoys the best of both worlds: outsize profits for its traders and shareholders and a taxpayer backstop should anything go wrong."
The piece is spiked with disdainful references to "the Goldmans of the world" and "the likes of Goldman, which apparently needs no help printing money," and takes issue with the way "we changed when we stepped in to save certain banks in the name of saving the system." It also dubs Goldman "Goldie Mac," saying: "Goldman will surely deny that its risk taking is subsidized by the taxpayer -- but then so did Fannie Mae and Freddie Mac, right up to the bitter end."
Compare that to the laudatory language and quotes used by AP business writer Stephen Bernard in his story yesterday on Goldman's "stunning" profit report. Bernard calls the company "the king of post-meltdown Wall Street" and repeatedly quotes a financial analyst who anoints Goldman as "the best of the best," "in a class by themselves," and "the golden child of the market."
The Journal's take -- "We like profits as much as the next capitalist. But when those profits are supported by government guarantees or insured deposits, taxpayers have a special interest in how the companies conduct their business" -- is actually more in keeping with that of Robert Reich, who says that "Goldman's resurgence should send shivers down the backs of every hardworking American who has lost a large chunk of retirement savings in this economic debacle, as well as the millions who have lost their jobs.... Goldman's high-risk business model hasn't changed one bit from what it was before the implosion of Wall Street."
Then there is Kessler's op-ed, which mirrors much of HuffPost's take on the serial missteps made by Obama's senior economic team. "We took the easy way out," he writes, "and, with the help of Treasury Secretary Timothy Geithner's loose 'stress tests,' swept banking problems under the carpet. We waved off mark-to-market accounting and juiced bank stock prices to help them recapitalize, but all those toxic mortgage assets on bank balance sheets are still there as anchors on lending."
Kessler also refuses to buy into the "'green shoots' psychology" that has spread through much of the media -- and rejects the all-too-frequent conflation of the Wall Street economy and the real economy: "By not restructuring banks, by not getting bad loans off bank balance sheets, by not standing up to the massive increases in government debt crowding out private capital, the Fed and Treasury are holding back real economic growth." There is much in the Wall Street Journal that I don't agree with but, when it comes to the failure of the administration to address and fundamentally reform what Kessler calls "the structural problems that got us into trouble in the first place," we are of the same mind.
There is no daylight between a progressive position focused on the paramount need to get the real economy going and one based purely on what makes free markets work. The editorial goes so far as to suggest imposing a tax (yes, the Wall Street Journal is proposing a tax!), an FDIC-style bailout tax to be precise, "for those in the too-big-to-fail camp." We've reached the point where the only people defending the administration's Wall Street policies are the people benefiting from them -- or their good friends, Tim Geithner and Larry Summers.
The Joy of Sachs
by Paul Krugman
The American economy remains in dire straits, with one worker in six unemployed or underemployed. Yet Goldman Sachs just reported record quarterly profits — and it's preparing to hand out huge bonuses, comparable to what it was paying before the crisis. What does this contrast tell us?
First, it tells us that Goldman is very good at what it does. Unfortunately, what it does is bad for America. Second, it shows that Wall Street's bad habits — above all, the system of compensation that helped cause the financial crisis — have not gone away. Third, it shows that by rescuing the financial system without reforming it, Washington has done nothing to protect us from a new crisis, and, in fact, has made another crisis more likely.
Let's start by talking about how Goldman makes money. Over the past generation — ever since the banking deregulation of the Reagan years — the U.S. economy has been "financialized." The business of moving money around, of slicing, dicing and repackaging financial claims, has soared in importance compared with the actual production of useful stuff. The sector officially labeled "securities, commodity contracts and investments" has grown especially fast, from only 0.3 percent of G.D.P. in the late 1970s to 1.7 percent of G.D.P. in 2007.
Such growth would be fine if financialization really delivered on its promises — if financial firms made money by directing capital to its most productive uses, by developing innovative ways to spread and reduce risk. But can anyone, at this point, make those claims with a straight face? Financial firms, we now know, directed vast quantities of capital into the construction of unsellable houses and empty shopping malls. They increased risk rather than reducing it, and concentrated risk rather than spreading it.
In effect, the industry was selling dangerous patent medicine to gullible consumers. Goldman's role in the financialization of America was similar to that of other players, except for one thing: Goldman didn't believe its own hype. Other banks invested heavily in the same toxic waste they were selling to the public at large. Goldman, famously, made a lot of money selling securities backed by subprime mortgages — then made a lot more money by selling mortgage-backed securities short, just before their value crashed. All of this was perfectly legal, but the net effect was that Goldman made profits by playing the rest of us for suckers.
And Wall Streeters have every incentive to keep playing that kind of game. The huge bonuses Goldman will soon hand out show that financial-industry highfliers are still operating under a system of heads they win, tails other people lose. If you're a banker, and you generate big short-term profits, you get lavishly rewarded — and you don't have to give the money back if and when those profits turn out to have been a mirage. You have every reason, then, to steer investors into taking risks they don't understand.
And the events of the past year have skewed those incentives even more, by putting taxpayers as well as investors on the hook if things go wrong. I won't try to parse the competing claims about how much direct benefit Goldman received from recent financial bailouts, especially the government's assumption of A.I.G.'s liabilities. What's clear is that Wall Street in general, Goldman very much included, benefited hugely from the government's provision of a financial backstop — an assurance that it will rescue major financial players whenever things go wrong.
You can argue that such rescues are necessary if we're to avoid a replay of the Great Depression. In fact, I agree. But the result is that the financial system's liabilities are now backed by an implicit government guarantee. Now the last time there was a comparable expansion of the financial safety net, the creation of federal deposit insurance in the 1930s, it was accompanied by much tighter regulation, to ensure that banks didn't abuse their privileges. This time, new regulations are still in the drawing-board stage — and the finance lobby is already fighting against even the most basic protections for consumers.
If these lobbying efforts succeed, we'll have set the stage for an even bigger financial disaster a few years down the road. The next crisis could look something like the savings-and-loan mess of the 1980s, in which deregulated banks gambled with, or in some cases stole, taxpayers' money — except that it would involve the financial industry as a whole. The bottom line is that Goldman's blowout quarter is good news for Goldman and the people who work there. It's good news for financial superstars in general, whose paychecks are rapidly climbing back to precrisis levels. But it's bad news for almost everyone else.
Earn Like Goldman Sachs, a How-To
Goldman Sachs has proved once again that it knows how to make money. Wednesday's announcement of a record quarterly profit of $3.44 billion ($) has spurred debate over how the bank did it. In addition to making money via its own trades, Goldman profits by advising clients about deals. Some of that advice has proved quite savvy. As we reported last year, one of Goldman's money-making strategies was to encourage some clients to bet on declines of the creditworthiness of a range of states — including California, New Jersey, New York and Florida. Goldman advised hedge funds to take the bets by buying credit default swaps, the insurance-like financial instruments that have been blamed for contributing to the financial meltdown last fall.
The strategy angered California Treasurer Bill Lockyer because his state was paying Goldman millions to help market the same bonds that Goldman was advising other clients to bet against. This week's announcement of huge profits — and the likelihood of near-record bonuses — at Goldman led us to wonder how much investors could have earned by following Goldman's controversial advice. Basically, if you had bought swaps against $10 million in California bonds in July 2008, it would have cost just under $80,000. Today, you could theoretically sell those swaps for $350,000 — making a 338 percent profit.
For bets on credit a downgrade of New York, the profit would have been 575 percent, according to data provided by Markit, which tracks credit default swaps. Of course, there are lots of caveats buried in these numbers. Notably, the prices assume that someone would want to buy the swaps, and that they would have the cash to do so. But fundamentally, it looks as if Goldman was right to advise clients that betting against states was a good way to make money. California didn't like it because, as Lockyer's spokesman said at the time, drumming up bets against California bonds could further undermine confidence in the state's ability to repay its debts.
That, in turn, could force the state to pay higher interest rates to borrow money, and cost taxpayers tens of millions at a time when the state is facing one of the worst budget crises in its history. So who are the people who've promised to pay up if California, or other states, cities and municipal entities, default? There's no way to know, because the swaps are still unregulated — though Congress is debating if and how to change that. For the record, it doesn't look as if many people followed Goldman's advice, which the company said it stopped giving around October.
Fewer than 200 contracts for swaps on California bonds are out, with a net value of just under $760 million, according to the Depository Trust and Clearing Corp. For Florida, there are 133 and for New York, there are 95. Those figures are dwarfed by the numbers of swaps on companies, such as Southwest Airlines, which has over 4,600 contracts covering nearly $2.5 billion of underlying debt. Even that is considerably fewer than the contracts on another company: Goldman Sachs. There are over 6,500 contracts on Goldman, covering $5.3 billion of debt.
This Sure Doesn't LOOK Like A New Bull Market
I have previously written that I am not particularly bullish or bearish on stocks right now, and believe that investors should have a normal or benchmark weight to the equity markets. There is no doubt that some news is improving. Monetary policy has caused volatility to decrease exactly as history would have suggested, initial jobless claims (the indicator that I feel should be investors' #1 economic indicator) is starting to improve regardless of the much-noted difficult seasonal adjustments, and the leading indicators of corporate profits growth appear to be bottoming. In addition, fiscal policy stimulus is still working its way through the various government procurement systems and is likely to boost economic growth.
On the other hand, there is still quite a bit of incremental bad news: Goldman Sach's recent earnings and compensation announcements are likely, in my opinion, to incite Washington to further regulate the financial sector, emerging market valuations are again (and perhaps too quickly) approaching extremes, credit growth remains subdued, and rising commodity prices are acting as a "tax increase" on the consumer and, therefore, are ultimately acting to stimulate deflation rather than inflation..
No one seems the least bit aware that leadership always changes during bear markets, but it hasn't changed during the recent market upturn. Either this cycle is going to be extremely unique and break a solid historical pattern, or this isn't the bull market that many believe. I find it particularly disconcerting that no one is discussing this historical fact, and are assuming that the prior cycle's leadership should be the new leadership.
Rising volatility and bear markets are caused by changes in the economic environment. The economic backdrop changes and the old leadership, which was suited for the prior economic environment, begins to underperform.
Volatility accordingly increases. A new market leadership begins to emerge that is better suited for the forthcoming economic environment. A dramatic example of this typical change in leadership occurred subsequent to the peak of the Technology bubble. As the Tech bubble deflated, the old leadership (technology/media/telecom stocks) was replaced by new leadership which was better suited for the soon to emerge easy-credit environment. It remains perplexing that many investors still don't appreciate that credit was the common thread among the global growth stories of the past 5-7 years. Commodities, housing, small stocks, emerging markets, hedge funds, private equity, short US dollar, etc. are all extremely credit-sensitive investments.
It concerns me that market rallies are being led by the prior cycle's leadership (financials, energy). This doesn't make a lot of sense if the global economy is heading into a period of more sober credit and lending, yet market observers seem to be ignoring this critical point. If the global economy is indeed returning to a credit-driven period, then of course one should overweight emerging markets, commodities, hedge funds, private equity, and sell short the US dollar. I'm skeptical that such cheap and available credit lies ahead, and suggest that investors sell the present credit-related market leadership into strength.
Recovery: Where Will the Jobs Come From?
Health care and education will keep adding jobs. Manufacturing employment will rebound as the global economy revives, but a big cut in the jobless rate will take years. The good news is that the downward momentum of the Great Recession is subsiding. The financial panic that seized the global capital markets has eased. CEOs are no longer acting as if depression looms. That said, the consensus forecast is for the economy to emerge slowly out of the downturn.
The recovery won't feel much like one, and that's bad news for a labor market where 6.5 million jobs have been lost since the recession began. With the unemployment rate climbing toward double digits, it isn't only Republican lawmakers who are wondering "where are the jobs?" "It's always the case that in the depths of the recession it's hard to say where the jobs will come from," says Barry Bosworth, economist at the Brookings Institution. So, where will the jobs come from? The White House Council of Economic Advisers recently asked just that question. To come up with an answer, the economists updated the Bureau of Labor Statistics' job projection numbers that were last published in 2007. The CEA's projections run from 2008 through 2016.
To some extent, the CEA's answer to the trillion-dollar question is: where they're coming from now. (See the accompanying chart.) Health care and education are two sectors of the economy that have expanded throughout the downturn, and both are expected to account for a major share of job growth over the next several years. Employers in all industries will favor workers with skill and education ranging from certificates earned at community colleges to higher degrees. On the other hand, retailing is likely to continue shrinking.
Cyclically, export-oriented industries should get a boost as the global economy revives. American-made goods are increasingly competitive, with the dollar relatively weak compared with other major foreign currencies. Indeed, Bosworth expects a sharp rebound in manufacturing employment, especially in the manufacturing-heavy Midwest. It wouldn't take much of a pickup in orders for manufacturing management to recall laid-off workers. "The long-term trend is bad," he says. "But the cyclical trend will be positive because it got clobbered so badly."
Economists believe there will be job growth over the next several years. The Great American Job Machine is grinding away slowly at the moment. But job creation is something the U.S. eventually does well. Problem is, it could take years to work down a 10%-plus unemployment rate to more acceptable levels, say, in the 5% range. Wages are likely to be anemic, too, considering how tough the competition will be among laid-off workers for jobs. Income inequality could worsen. "I'm reasonably confident about the state of employment," says Joshua L. Rosenbaum, economist at the University of Kansas. "I worry more about the income level we will have."
The wild card in all this is that job forecasts are notoriously unreliable. The reason is technological innovation and the discovery of new ways of doing business. Innovations can generate jobs—if they materialize. For instance, in 2003 a quarter of American workers were in jobs that weren't listed in the Census Bureau's occupation codes in 1967. You sure won't find words like "Web designer" or "mobile-phone salesperson" in the LBJ-era list.
"What's unpredictable are the physical gizmos that will trigger a multiplier effect with employment," says Amar Bhide, visiting professor of economics at the Kennedy School of Government at Harvard University. Daniel Boorstin, the late historian, captured the dynamic this way in a 1987 essay: "Who, for example, could have predicted that the internal-combustion engine and the automobile would breed a new world of installment buying, credit cards, franchises, and annual models—that they would revise the meaning of cities, and even transform notions of crime and morality with no-fault insurance." Problem is, no one can say whether such innovations will appear. Until they do, the prospect is for higher unemployment in the short run and a slow climb into mostly knowledge-based jobs somewhere down the road. The jobs machine may have to wait for a new power source to kick it back into high gear.
S&P 500 Rally Poised to End, DeGraaf Says
The 34 percent rebound in the Standard & Poor's 500 Index since March shows few hallmarks of a bull market, and stocks will probably stagnate for years, top- ranked analyst Jeffrey deGraaf said. The S&P 500 is at a level it first surpassed in 1997 even after the steepest quarterly advance in a decade, and is down 43 percent from its October 2007 record, according to data compiled by Bloomberg. The main benchmark for American equities probably will continue to make "no net price progress" for at least two more years, deGraaf said in an interview. The index rose to 905.84 yesterday.
"The market in my best estimation is probably range-bound between roughly 1,000 on the upside and 700 on the downside, but I would put the risk to the downside," he said. DeGraaf is a senior managing director at ISI Group Inc. in New York and was the top-ranked technical analyst in Institutional Investor magazine's poll for the past four years. Technical analysts base predictions on price and volume charts. Investors who took deGraaf's advice when the advance began were rewarded. In a Bloomberg Television interview on March 13, he described the gain as the "best bear-market rally that we've seen during this bear market." The S&P 500, which had advanced 11 percent from the March 9 low as of that date, climbed another 26 percent to a seven-month high of 946.21 on June 12.
Since then, there's been "a definite decrease or decay in the position of the bulls" as measured by volume and the numbers of advancing and declining shares, deGraaf said. Since May, volume on the New York Stock Exchange has averaged 1.24 billion shares a day, compared with 1.63 billion a day during the previous 12 weeks. At the same time, drops in the prices of some commodities and strength in the Japanese yen relative to higher-yielding currencies such as the Australian dollar indicate that investor confidence in the global growth outlook is waning, deGraaf said. The aftermath of a credit crisis such as last year's, in which banks globally lost $1.47 trillion as debt default rates climbed, creates conditions that "have a tendency to foster more trading ranges than they do trends," deGraaf said. Declining worker productivity is one such obstacle, he said.
The U.S. stock market may follow a path similar to Japan's benchmark Nikkei 225 Stock Average from 1992 to 2000, he said. The average fell 40 percent during that span even as it posted five quarterly advances of at least 10 percent. "Japan from 1992 to 2000 was in what aviators call a phugoid -- which is just this long oscillation in price," deGraaf said. "It looks to us like there's a reasonable probability that we're going to enter into a similar period, with more government intervention and all these things that tend to come about after a bubble, particularly one that's been driven by credit."
Ilargi: I don't think I've posted this particular video beofre. It's well done. But I must admit I'm getting a bit tired of the "Audit the Fed" theme. Sounds nice and all alright, I know. One question though: on whose authority? What irt comes down to is that you can't audit the Fed without abolishing it. Which is not something I would fight against. Still, a dose of reality is called for. It's not going to happen, that audit.
The Fed Under Fire
FOMC Forecasts - Reality or Fantasy?
It takes some time to work through the minutes from the June FOMC meeting. They are, in the words of David Altig, "meaty." Altig concentrated his remarks on the implications of the Fed's balance sheet explosion. I found myself pulled to the various economic projections spread throughout the minutes. Do those projections pass the laugh test? Are they realistic? Are they optimistic? Or just plain delusional? I think a little of all those descriptions are accurate.
The staff's projections comes first, and appear to be what Calculated Risk describes as an "immaculate recovery":In the forecast prepared for the June meeting, the staff revised upward its outlook for economic activity during the remainder of 2009 and for 2010…The staff projected that real GDP would decline at a substantially slower rate in the second quarter than it had in the first quarter and then increase in the second half of 2009, though less rapidly than potential output. The staff also revised up its projection for the increase in real GDP in 2010, to a pace above the growth rate of potential GDP. As a consequence, the staff projected that the unemployment rate would rise further in 2009 but would edge down in 2010. Meanwhile, the staff forecast for inflation was marked up. Recent readings on core consumer prices had come in a bit higher than expected; in addition, the rise in energy prices, less-favorable import prices, and the absence of any downward movement in inflation expectations led the staff to raise its medium-term inflation outlook. Nonetheless, the low level of resource utilization was projected to result in an appreciable deceleration in core consumer prices through 2010.
Looking ahead to 2011 and 2012, the staff anticipated that financial markets and institutions would continue to recuperate, monetary policy would remain stimulative, fiscal stimulus would be fading, and inflation expectations would be relatively well anchored. Under such conditions, the staff projected that real GDP would expand at a rate well above that of its potential, that the unemployment rate would decline significantly, and that overall and core personal consumption expenditures inflation would stay low.
Leaving aside inflation (which will stay low over the long term if you assume that expectations remain anchored), the staff upgraded the forecast for 2009, is expecting growth to rebound to potential next year (which, is now less than six months away) and then acce lerate further in subsequent years. Is such optimism justified? Yes and no.
I think it is fair to say that mounting evidence points to the formation of a rather clear bottom in the most recent stage of this economic cycle. Hear I refer to the sharp contractions beginning in late 2008, not to the "official" start of the recession in December 2007. Indeed, I think one would have to be almost blind to not see the clear signals emerging in a wide range of data, such as the ISM data:
See also consumption data:
Not to mention to mention the initial claims data (see CR and his caveats). To be sure, one could worry that industrial production continues to fall, but note the rate of decline is slowing and capacity utilization looks to be stabilizing. Moreover, the recent stability in auto sales will lend support for manufacturing in the months ahead:
Notice that the vehicle sales increased 1.3% during the quarter, pointing to a gain in this component of GDP. As always, do not underestimate the data impact of moving from significant declines to just flattening out. With such clear evidence of bottoming out emerging, not only does the near term data get a boost, but downside risks fall - and both point to upward revisions of near term forecasts.
The more interesting parts of the staff's forecast are in the 2010 and beyond range. The fact that they suggest immaculate recovery, I suspect, is largely a model driven outcome. Econometric models tend to force forecasts back to trend, and, in this case, are likely fighting with a large gap between actual and potential GDP. The only way to close that gap is through rapid growth which would in turn lead to "significant" declines in the unemployment rate.
How should we handicap this optimistic forecast? First off, I would remind readers that the bar has been lowered. The long run growth forecast from the FOMC participants are in the 2.5-2.7% range. While this is not a revision, I think commentators tend to forget how much the bar has been lowered since the late 1990s, when some foresaw potential growth as 4% or higher. Likewise, I believe evidence was building prior to the recession that the corresponding job growth rate is around 100k a month. In other words, 100k holds the unemployment rate roughly steady, rather than the 150k that is commonly suggested. In short, diminished expectations likely help the forecast clear the hurdle of reducing the unemployment rate in 2011 and beyond.
Moving toward the diminished expectation for potential output, I suspect, will not be terribly hard to accomplish. Stabilizing consumer spending itself will go a long way toward keeping GDP growth in positive territory as will just a lessening of the inventory drag. Moreover, fiscal stimulus will add positively over the next year, as will the external sector, especially if China can maintain its current dynamic and a weakened US consumer continues to weigh on import growth. And if consumer and export spending hold together, then investment spending will also cease to be a drag.
That said, positive territory for growth could easily be consistent with an economy limping along above recession but insufficient for any significant job growth, a scenario that remains my favorite. Given that 70% of the economy is driven by consumer spending, I find it hard to believe that you can supercharge growth well above potential without the active participation of households. We know, however, that households continue to struggle under heavy debt burdens which, combined with the now tighter underwriting conditions that are likely to be more permanent than temporary, suggest that spending growth is likely to be constrained sufficiently to prevent supercharged growth. I would imagine that to propel consumption growth to rates consistent with the staff's forecast, the staff must be anticipating significant real wealth gains sufficient to drive savings rates back to zero. That, I believe imply a housing rebound…which I can't see unless conditions revert back to the "let's give everyone one with a pulse a loan" era.
Could the Fed staff really believe that the stage is set for such a rebound? More importantly, could FOMC members? Perhaps some do, at least that is the impression from the growth projections:
The range of growth expectations is quite wide, as noted in this Bloomberg article. Some policymakers are expecting a solid V shaped recovery evolving in 2010, while the other side of the spectrum is looking for a more gradual acceleration to potential growth (the scenario I tend toward). The latter scenario suggests a jobless recovery, with growth insufficient to make much of a dent in unemployment. From a policy perspective, such a scenario points to additional pressure to ease further, complicated by the unknown impact of general balance sheet expansion. It certainly does not point to any rush to unwind the liquidity/credit support programs. The optimistic view implies the opposite, a concern that programs need to be unwound quickly, with a rapid move to normalize interest rates. Until the 2011 forecast comes more fully into view, sometime around the second quarter of 2010, policy will remain in a holding pattern. But note that the wide range of forecasts imply a wide range of Fedspeak, which will lend an irritating feature to the discourse: Seemingly opposite opinions nearly side by side in the press.
A final point: The range of forecasts, both high and low, can be used to argue against another stimulus package as the direction of growth is headed in the right direction. This is especially the case if unemployment stabilizes, even if at a relatively high level. Moreover, note that US Treasury Secretary Timothy Geithner is on something of a world tour, first China, now the Middle East, promising US fiscal restraint:"Policies of the United States are designed to lay the conditions for a strong dollar," Mr. Geithner said on Tuesday, adding: "We are very committed ... to making sure that as we get through the crisis, we bring down fiscal deficits and we reverse these extraordinary interventions we've taken."
I suspect conditions would need to deteriorate markedly in order to force the Administration to push a fresh round of stimulus. That is not the Fed's projection.
Bottom Line: Clear signs of a bottom are an obvious reason to stabilize and boost near term forecasts. Still, the Fed staff's projections appear overly optimistic, seeming to imply that future dynamics will be very similar to the past. I am skeptical. Remember to take forecasts relative of potential GDP in context of diminished expectations. The wide range of projections speaks to an interesting spectrum of Fedspeak in upcoming months. The game will be to track the data, being wary not to read to much into a short-lived bounce off the bottom. I side with the low end of the FOMC forecasts; call me a pessimist. Place your own bets, being prepared to adjust with the data.
Obama Names Goldman Sachs's Hormats to State Department Post
President Barack Obama announced today he was nominating Robert Hormats, a vice chairman of Goldman Sachs International, to a top economic position at the State Department. Hormats, 66, will serve as undersecretary of state for economic, energy and agricultural affairs. He served as deputy U.S. trade representative from 1979-1981 and in other posts at the State Department throughout his career. Secretary of State Hillary Clinton said in a speech July 15 that she hoped to make economic policy and trade a larger part of U.S. diplomacy. "The role of the economic agenda of the State Department needs to be strengthened," Clinton said. Obama also is nominating Lee Feinstein, an adviser to Clinton, as ambassador to Poland, the White House announcement said.
Banks' red ink shows consumers still bruised
Bank of America Corp and Citigroup Inc raised huge red flags on Friday with quarterly results that suggested the U.S. consumer remains sorely injured as the global recession drags on.
Both Bank of America, the largest U.S. bank, and Citigroup, No. 3, reported big increases in delinquencies among credit card customers and warned that things will get worse. The results also indicated it will take time to scrub the worst effects of soured loans to mortgage and business customers off the banks' balance sheets.
"All in all, our quarter comes down to mortgage and credit card losses," said Citigroup Chief Executive Vikram Pandit. "Cards and mortgages are what we need to work through." That could signal more trouble for an industry whose failures large and small helped drive the economy into recession 19 months ago, a downturn that shows little evidence of coming to an end. "Credit issues are already serious, and we still haven't seen the full fallout from commercial real estate," said Bill Fitzpatrick, an analyst at Optique Capital Management in Milwaukee. "Bank of America and Citigroup have raised a lot of capital, which can help them stomach the losses we know are coming."
The banks' results contrast with much better performances reported earlier this week by Wall Street rivals Goldman Sachs Group Inc and JPMorgan Chase & Co. But the results didn't shock analysts and were enough to help financial stocks hang on to strong recent gains. Shares of Bank of America dropped 2 percent on the New York Stock Exchange, while Citigroup was fractionally higher. The S&P Financial index, which jumped more than 10 percent in the first four trading days this week, was down 1.15 percent.
Bank of America, under pressure to integrate its shotgun acquisition of Merrill Lynch & Co, warned of a fresh surge in loan delinquencies, especially in credit cards, and set aside $13.38 billion for bad loans for a second straight quarter. Net income was $2.42 billion, topping Wall Street forecasts. Citigroup, whose headline $4.28 billion quarterly profit was due to gains from the sale of its Smith Barney brokerage into a joint venture, said credit costs jumped by $12.4 billion, including the addition of $3.9 billion to loan loss reserves.
"They both seem to reserve a lot for credit losses in all parts of the business. That's the bad news," said Walter Todd, portfolio manager at Greenwood Capital Associates in South Carolina. "The good news is the bank earnings looked really strong, which should be the case." Still, the results could sharpen scrutiny of the banks' management, particularly their ability to manage risk after the U.S. government stepped in with a series of bailouts and a $787 billion economic stimulus program. Bank of America and Citigroup each received $45 billion of taxpayer funds.
Consumer surveys show concern over mounting U.S. job losses, and mixed views of the Obama administration's strategy for economic recovery. U.S. home foreclosure activity rose to a record high in the first half of the year. The banks' results also underline how the industry, girding for the most sweeping regulatory reform since the Great Depression, is still under immense pressure from credit losses.
"You look at these numbers and I would have to think there's still a lot of caution," said Fred Ketchen, director of equity trading at ScotiaMcLeod in Toronto. "I don't think they have taken any of that concern away. There are still some challenges to overcome in the U.S. financial sector." Most remaining large U.S. banks are due to report quarterly results next week, including Wells Fargo & Co and Morgan Stanley.
Citigroup Posts $4.28 Billion Profit on Smith Barney
Citigroup Inc. posted a $4.28 billion profit, less than analysts estimated, as surging loan losses cut into a gain from selling control of the Smith Barney brokerage unit. Second-quarter earnings were 49 cents a share, compared with a loss of $2.5 billion, or 55 cents, a year earlier, New York-based Citigroup said today in a statement. Excluding the Smith Barney gain of $6.7 billion, Citigroup had an operating loss of 62 cents a share. That compared with a 33-cent average loss estimate of 12 analysts in a Bloomberg survey.
Consumer and business loan delinquencies kept rising, giving Chief Executive Officer Vikram Pandit little relief from the financial crisis that forced him to take a $45 billion government bailout and unload some of his biggest units. The bank, once the nation's largest by assets, now ranks third after Bank of America Corp. and JPMorgan Chase & Co. "This company is going to be shrinking," said Ed Najarian, an analyst at institutional brokerage International Strategy & Investment Group in New York. "You've got to factor that into your analysis of the ability to absorb losses over the next 18 months." The bank's costs for bad loans in the quarter jumped by 75 percent to $12.2 billion. Late credit-card loans increased to 3 percent of the total, from 2.1 percent a year earlier.
Smith Barney, now part of a joint venture controlled by former Pandit employer Morgan Stanley, had $10.2 billion of revenue last year, or 19 percent of Citigroup's total. The results included costs of $1.6 billion taken under a bookkeeping rule that forces banks to account for increases in the market value of some of their liabilities. Citigroup recorded a $2.5 billion gain from the rule in the first quarter, when concerns about the bank's creditworthiness led to declines in the value of the liabilities. Investor confidence in Citigroup rose during the second quarter, as measured by prices for its bonds, leading to an increase in the liability values.
In a June 30 report, Jeff Harte, an analyst at Sandler O'Neill & Partners LP in Chicago, had predicted $1.4 billion of costs from the accounting rule. Citigroup also recorded a $333 million cost after the Federal Deposit Insurance Corp. on May 22 assessed a fee on banks to help replenish the agency's bank-rescue fund. Harte had estimated the fee at $296 million on a pretax basis. The results were "somewhat encouraging," because the bank didn't have to set aside as much for future loan losses as some investors expected, Gary Townsend, chief executive officer of Hill-Townsend Capital LLC in Chevy Chase, Maryland, said in a Bloomberg Television interview.
"We'll be watching how quickly they're able to sell off assets like Smith Barney and use that to reinforce the capital structure, and eventually build what they have to have to repay the government," Townsend said.
Citigroup gained 4 cents, or 1.3 percent, to $3.07 in composite trading on the New York Stock Exchange at 10:59 a.m. The company's shares are still down from a December 2006 peak of $56.41. They jumped 17 percent this week through yesterday amid economic reports signaling the worst of the recession may be over.
The businesses that Pandit plans to keep, grouped in a division called Citicorp, had a $3.06 billion profit in the quarter, down 11 percent from a year earlier. Stock-trading revenue fell 28 percent to $1.1 billion and private-banking revenue fell 20 percent to $477 million, overwhelming a 26 percent gain in fixed-income trading revenue to $5.57 billion. Debt underwriting climbed 14 percent to $751 million. Citi Holdings, the division of businesses that Pandit is selling or winding down, including the Smith Barney results, had a $1.36 billion profit, compared with a $5.23 billion loss reported a year earlier. Absent the Smith Barney gain, the division had a $5.36 billion loss.
"Our most significant challenge now remains consumer credit," Pandit said in the statement. "Losses in our consumer businesses have been growing for some time, but we see some positive signs of moderation in those loss trends." Citigroup's operating loss contrasted with profits posted by its biggest rivals. Charlotte, North Carolina-based Bank of America said today second-quarter profit was $3.22 billion. New York-based JPMorgan yesterday reported second-quarter earnings of $2.7 billion, up 36 percent. On July 14, Goldman Sachs Group Inc., which also has its headquarters in New York, posted a 65 percent increase in profit to $3.44 billion.
Citigroup plans to dilute current shareholders by 76 percent under a plan to convert $33 billion of preferred shares and $25 billion of the government's bailout stake into common stock. Under that conversion, set to begin as soon as this month, the government would end up with a 34 percent stake. Pandit, 52, who took over in December 2007 following the ouster of Charles O. "Chuck" Prince, has sold 23 businesses since then and cut jobs from a workforce that had ballooned to 375,000 employees.
The former hedge fund manager and Morgan Stanley investment banker now says he wants to cast off operations outside of branch banking, investment banking and trading to remake Citigroup as a one-of-a-kind financial institution able to serve consumers and multinational corporations in more than 100 countries. Pandit said in a June 15 speech in Detroit that he expects slow U.S. economic growth in coming years because Americans are saving more and borrowing less. That means Citigroup must use profits from its global banking network, especially in emerging markets, to restore its health, he said.
"As every businessperson knows, the best way to repay debt is to earn your way out of it," Pandit said. In the second quarter, the bank's international revenue wasn't insulated from the global economic slowdown. Citicorp's consumer-banking operations in Asia had a profit of $272 million, down 40 percent from a year earlier. In Latin America, consumer-banking had a $70 million profit, down 79 percent. In Europe, the business had a loss of $110 million, compared with a $37 million profit a year earlier. In the U.S. and Canada, consumer-banking had a $15 million loss, compared with a $169 million profit.
FDIC Chairman Sheila Bair has questioned Pandit's leadership and wants the bank to reduce risks by selling businesses, including some overseas, people familiar with the matter said earlier this month. On July 9, Citigroup replaced Edward "Ned" Kelly as chief financial officer after FDIC officials told Chairman Richard Parsons they were concerned Kelly lacked the proper credentials, people familiar with the matter said last week. Kelly was shifted to a role overseeing strategy.
"For any of the major banks right now, they are under the microscope and there is a lot pressure on them," Peter Sorrentino, who helps oversee $13.8 billion at Huntington Asset Management in Cincinnati, said in a Bloomberg Television interview. "It is very difficult in this climate to do what you believe to be the right thing when you have got so many constituencies looking over your shoulder." Kelly's replacement as CFO, John Gerspach, had eight days to prepare for an 11 a.m. conference call today with analysts and investors. He and Pandit are scheduled to brief them on the bank's efforts to shrink its roughly $1.85 trillion balance sheet and grapple with another $165 billion of off-balance-sheet assets that may have to be consolidated under pending accounting rules.
Bank of America Posts Profit Drop, Sees Weak Economy
Bank of America Corp., the biggest U.S. lender, said second-quarter profit declined and the company set aside more money for losses as Chief Executive Officer Kenneth Lewis predicted the weak economy will persist into 2010. Net income fell 5.5 percent to $3.22 billion, or 33 cents per diluted share, from $3.41 billion, or 72 cents, a year earlier, the Charlotte, North Carolina-based bank said today in a statement. The stock slipped 2.4 percent in New York trading.
Bank of America's report follows better-than-expected results from JPMorgan Chase & Co. and Goldman Sachs Group Inc. earlier this week. While competitors have repaid U.S. rescue funds and freed themselves of extra U.S. scrutiny, Lewis must repair relations with regulators after clashes over the bank's pursuit of Merrill Lynch & Co. and demands that he raise $33.9 billion in capital. "We have to get through the next few quarters," Lewis said on a conference call. "Profitability in the second half will be much tougher," he said, citing the anticipated absence of one-time gains that boosted results so far this year.
Bank of America declined 28 cents, or 2.1 percent, to $12.89 at 12:17 p.m. in New York Stock Exchange composite trading. Citigroup Inc. said today it swung to a second-quarter profit, beating analysts' estimates, and the stock advanced as much as 5.6 percent. Profit in global banking increased 74 percent to $2.49 billion at Bank of America, aided by a gain from selling the merchant processing business. Earnings at the unit that includes trading of bonds, equities and currencies more than quadrupled to $1.38 billion on improved credit markets.
The home loan and insurance unit lost $725 million, even as revenue tripled, on credit costs and expenses to help homeowners modify their loans. The bank sees signs that some loan losses may abate, with late payments flattening and home prices stabilizing in California's hardest hit markets, Lewis said. Card services swung to a loss, and the new federal law curbing interest rates and fees may slice revenue, the bank said. The provision for credit losses, money set aside to cushion against bad debts, was $13.38 billion, the same as the previous quarter. Assets no longer collecting interest rose to $30.98 billion from $25.6 billion on March 31 and debts the bank doesn't expect to be repaid jumped 25 percent to $8.7 billion.
The credit-card unit's $1.62 billion loss compared with a $582 million profit last year. New regulations approved by Congress may trim revenue from cards by as much as $700 million in 2010, Lewis said. "It's enough to get your attention," he told analysts, adding that the bank is looking for ways to mitigate the damage. Bank of America suffered rising defaults on real-estate loans tied to retail and office properties, while the level of troubled loans to home builders and developers stabilized, Chief Financial Officer Joe Price said.
One-time items included a gain of $5.3 billion from the sale of a stake in China Construction Bank Corp. and dividend payments to the U.S. bank rescue fund, which holds $45 billion of preferred stock. Bank of America posted its second straight quarterly profit after a $1.7 billion loss in the last period of 2008, its first losing quarter in 17 years. Federal Reserve stress tests in May found the company may face as much as $136 billion in losses through 2010, and regulators told the bank to raise more capital. Lewis, 62, said U.S. officials were underestimating the bank's earnings power, and then raised more money than they demanded, ending the campaign with about $38 billion.
Regulators and lawmakers have pressured Lewis to prove that agreements last year to buy Countrywide Financial Corp., the biggest U.S. home lender at the time, and Merrill Lynch, the largest brokerage, can pay off as unemployment reaches the highest level since 1983. Countrywide was acquired a year ago after the home lender almost collapsed under the weight of defaulting subprime home mortgages. Merrill's acquisition "is going to work out," said Bill Fitzpatrick, an equity analyst at Optique Capital Management, which manages $900 million, including Bank of America shares, in Racine, Washington. "That's why they are profitable here in the second quarter. They would not be, outside of the Merrill Lynch revenue."
Lewis had considered backing out of the Merrill Lynch purchase in December as losses spiraled toward more than $15 billion in the fourth quarter. The bank completed the deal in January after then-Treasury Secretary Henry Paulson threatened to have Lewis ousted if the deal was scuttled because regulators feared Merrill would collapse and threaten the financial system. Shareholders stripped Lewis of his chairman's title in April after criticism that he withheld information about Merrill's mounting losses, and his tenure may face more scrutiny from the U.S. Documents tied to the Merrill bailout, dated Dec. 21 and released at a congressional hearing yesterday by Representative Dennis Kucinich, an Ohio Democrat, show regulators planned "more intrusive review and involvement by the U.S. government in the selection of management" and the board in return for U.S. funds to salvage the Merrill deal.
The resulting package included $20 billion in new capital and $118 billion in asset guarantees. The latter accord was never signed or tapped, generating another clash with regulators over whether Bank of America owes part of a promised $4 billion fee to the U.S. The bank told analysts that issue will probably be resolved within the next 30 days. Separately, regulators told the bank in a May memorandum of understanding to overhaul its board and improve risk and liquidity management, said a person familiar with the matter.
Former lead director Temple Sloan and five other former bank directors resigned since the April annual meeting, while four new directors with banking and regulatory experience joined the board. Chief Risk Officer Amy Brinkley also announced her resignation during the quarter as a Congressional investigation of the Merrill transaction revealed Fed and Treasury officials' criticism of Bank of America's risk-management practices. "Both Merrill Lynch and Bank of America are on a healthy track and the $38 billion capital raise shows the markets gave a resounding endorsement of the company, which in combination is a very strong report card on Ken," bank spokesman James Mahoney said yesterday. "The board has also strongly endorsed Ken's leadership."
While Lewis faces pressure from regulators, bank investors believe government is delving too much into a private company's affairs, Andrews said. "The more the government leans on Ken Lewis, the more investors are going to rally around him," he said.
GE second-quarter profits fall by 47%
General Electric's quarterly profit plunged by almost 50 per cent as slumping economies crimped demand for industrial equipment. Net income from continuing operations fell by 47 per cent to $2.9bn, or 26 cents a share in the second quarter. Per-share earnings beat analysts' average estimate of 24 cents as cost cuts and tax benefits helped offset disappointing top-line results. Total revenue slipped 17 per cent to $39.1bn, short of expectations. GE's shares lost 6.1 per cent to $11.64 in early afternoon trading in New York.
"In a global economic environment that continues to remain challenging, GE delivered solid second-quarter business results," Jeff Immelt, GE's chief executive, said in a statement. "We are executing through the recession by aggressively controlling costs and driving working capital improvements while continuing to invest for future growth." Finding little reason to believe an economic rebound was imminent, GE trimmed its profit forecast for its industrial and media businesses. In a conference call with analysts, Jeff Immelt, chief executive, said earnings from the company's non-financial divisions would be flat this year; in December he had forecast growth of as much as 5 per cent.
While GE's industrial businesses, which range from aircraft engines and wind turbines to medical imaging machines, boast a record backlog of $169bn, new equipment orders slipped 42 per cent during the second quarter to $8.5bn. Service orders rose 2 per cent in the period. Investors remained wary of GE Capital, whose earnings slumped 80 per cent during the quarter from a year ago. In spite of its struggles, Mr Immelt said the division was "ahead of schedule" in its timetable to become a more "focused" financial services company and remained on track to be profitable for the year. GE has continued to shrink GE Capital's portfolio of commercial and consumer loans and reduced its borrowing needs.
The company's executives also sought to make its case against a provision in the Obama administration's sweeping plan for financial-services industry reform that would call for separate commercial and financial entities. The proposal prompted speculation that GE would be forced to divest its finance arm. "We have talked to a number of people in Congress, and we have heard considerable scepticism about many of the features of the white paper, but particularly on this aspect of the white paper," said Brackett Denniston, GE's general counsel.
"And we have also heard considerable support for the idea of not breaking up the existing structures for grandfathering." The industrial, technology and media divisions also saw profits fall. Earnings at NBC Universal were off by 41 per cent as advertising revenue plunged. Only GE's energy infrastructure unit showed growth in the quarter. The Connecticut-based company has increasingly looked overseas to expand into markets with more growth potential. GE boasted that industrial revenues were up by 31 per cent in China and 46 per cent in India.
Last month GE announced a $500m deal to supply new gas and steam turbines to the Kingdom of Bahrain as the company continues to push for a greater presence in the Middle East to counteract troubles in its domestic market. It also recently announced an $8bn commercial finance joint venture with Mubadala Development, Abu Dhabi's state investment vehicle. Shares of GE fell by 5.7 per cent to $11.7 by mid-afternoon on Friday and are off by 62 per cent from their 12-month high.
Real Estate Worries Some GE Analysts
General Electric is likely to meet analyst earnings expectations Friday before the market opens. But investors may ignore that news. Instead they will look carefully at what GE acknowledges is a trouble spot: real estate. GE's profit will be half what it was a year ago, and it can thank the government for a portion of those earnings. GE has been one of the biggest beneficiaries of government-assistance programs. Investors will focus on GE Capital, which represented about 35% of GE's net income in the first quarter, and continues to battle losses and delinquencies.
Real estate represented 13% of GE Capital's assets at year end, and a hefty chunk of its then-$85 billion real-estate portfolio represents more-risky equity exposure, rather than debt. Deutsche Bank predicts a $191 million loss in GE Capital's real-estate-equity division in the quarter, down from a $484 million gain in the same period a year ago. Compared with real-estate losses at other firms, GE's may be smaller, leaving investors to gripe that the valuations of GE's holdings are higher than they should be.
GE must use accrual accounting methods that don't mark to market real-estate declines. Some banks generally need to mark to market, like Goldman Sachs; commercial real estate proved a rare chink in Goldman's strong second-quarter results this week. Hedge fund FrontPoint Partners, which made the case for GE as a short position earlier this year, estimates GE has as much as $20 billion or $25 billion in future losses in its real-estate portfolio on a mark-to-market basis. GE acknowledges the challenging environment but says it is a moot point because it plans to hold assets. It says it has been careful in its real-estate deals and in managing losses.
In March, GE said it had a 1.2% delinquency rate, compared with 5.4% for commercial banks. Several analysts maintain GE's provisions for overall losses within GE Capital should be higher and continue calling for GE to set aside more cash to cover losses in GE Capital. GE's plan on that score will be something they will look forward to hearing more about on the company's call.
The Earnings Bomb Inside GE Capital
GE (GE) gave a presentation a few weeks ago designed to calm investors' fears that the company's huge financial services division, GE Capital, is just another Bear Stearns with a friendly logo. The presentation helped, and GE's stock has recovered some of its horrific losses. As of this morning, it's back above $11 (down from $40+ 18 months ago).Some investors, however, are not convinced. The inimitable Steve Eisman of FrontPoint Partners, for example, who was immortalized last year in Michael Lewis's article about the end of Wall Street, detailed his thoughts about GE at Jim Grant's annual conference a few days ago.
An investor in attendance was kind enough to forward Steve's slides, and we've excerpted some of them below. Here's his bottom line:
GE Capital is currently hiding $40-$45 billion of embedded losses in the GE Capital portfolio. This $40-$45 billion of losses, if rinsed through the income statement all at once, would wipe the company out. In fact, if GE weren't able to fund itself with the "heroin injection" of the government's commercial paper program, it would already be bankrupt.
So is GE toast?
No. Unlike banks, GE is not required to mark its assets to market, so Eisman thinks the company will just hobble along for years as the bad news gradually works its way through its income statement (the very definition of a zombie bank). The losses will hammer GE's earnings, though. Especially as the performance of the industrial business deteriorates.
We asked a GE analyst why the company seems unwilling to acknowledge this:
"Because they're living on Planet GE," he said--"which is not even in this solar system."
Here are some of Steve Eisman's slides:
First, the bottom line: $41-$46 billion of embedded losses (bear in mind that these are all estimates. GE would probably violently disagree):
And now the details... Eisman says GE's asset quality is low and that the company under-reserves relative to its competitors:
If GE were to increase its reserves to match the rest of the industry...
This would result in a huge hit to pre-tax earnings:
Next, the specific assets. If GE's financial investments were marked to market, the company would have to take an estimated $9 billion loss.
Marking GE Capital's securities to market would result in an estimated $5 billion hit.
Next, GE's residential European mortgage portfolio. The Polish and Hungarian mortgages are paid in Swiss Francs. Unfortunately, the folks who are supposed to pay them are paid in zlotis, etc--and the value of these currencies has plummeted against the Swiss Franc. Steve Eisman re-calculates the loan-to-value ratios in the local currencies:
The UK mortgage portfolio is hurting, too.
Then there are GE's Commercial Real Estate holdings. Eisman thinks this portfolio is worth up to 40% less than its carrying value. Why? Because most of the holdings (securities and buildings) were acquired at the peak of the market. An investor familiar with GE's real-estate investment timing described GE's timing this way: "Why don't you just put a fucking gun to your head and blow your brains out?")
Add all this up, Steve Eisman says, and you get $41-$46 billion of embedded losses on a $600 billion book of assets--enough to cripple GE's earnings for years.
Roubini: Views on Economy Unchanged Despite Reports
Nouriel Roubini, the economist whose dire forecasts earned him the nickname "Doctor Doom," said after markets closed Thursday that earlier reports claiming he sees an end to the recession this year were "taken out of context." "It has been widely reported today that I have stated that the recession will be over 'this year' and that I have 'improved' my economic outlook," Roubini said in a prepared statement. "Despite those reports ... my views expressed today are no different than the views I have expressed previously. If anything my views were taken out of context."
Several business news outlets, picking up on a report initially from Reuters, earlier Thursday cited Roubini as saying that the worst of the economic financial crisis may be over. The New York University professor was quoted by Reuters as saying that the economy would emerge from the recession toward the end of 2009. Reports of his comments helped trigger a late rally in the stock market. Roubini added late Thursday that he sees no economic growth before the end of 2009.
"I have said on numerous occasions that the recession would last roughly 24 months. Therefore, we are 19 months into that recession. If as I predicted the recession is over by year end, it will have lasted 24 months with a recovery only beginning in 2010. Simply put I am not forecasting economic growth before year's end." Roubini predicts a shallow recovery, with growth averaging about 1 percent over the next few years. He also sees the possibility, he reiterated, of a "double-dip" recession toward the end of next year.
"On one side, early exit from monetary and fiscal easing would tip the economy into a new recession as the recovery is anemic and deflationary pressures are dominant," Roubini said. "On the other side, maintaining large budget deficits and continued monetization of such deficits would eventually increase long term interest rates ... and thus would lead to a crowding out of private demand. "While the recession will be over by the end of the year the recovery will be weak given the debt overhang in the household sector, the financial system and the corporate sector; and now there is also a massive re-leveraging of the public sector with unsustainable fiscal deficits and public debt accumulation."
British Airways turns to pension fund in £600 million cash call
British Airways has announced plans to raise more than £600m of fresh funding in an attempt to avoid being dragged into involvency by the slump in the aviation sector. The cash-strapped airline will raise £300m by selling convertible bonds and take control of another £330m in bank guarantees that had previously been set aside for its pensioners in the event of the airline falling into insolvency. This comes just three days after BA warned it might not have enough liquidity to survive the economic downturn.
The chief executive, Willie Walsh, said the company was taking action to "strengthen our position within the industry". "This goes hand-in-hand with our cost reduction and efficiency initiatives, which are designed to create the right conditions for our sustainable, long-term profitability. It also supports our continued investment programme to maintain our position as a leading global premium airline," Walsh added. BA revealed this morning that it expected to have lost about £100m between May and July, adding to the record £401m loss it suffered in the last financial year.
"It's always disappointing to make a loss, but this is better than the market expected," said Walsh. The funding moves announced today will raise BA's total cash reserves to about £2bn. A BA spokesman said that its pension trustees had agreed to hand over the bank guarantees – effectively a £330m overdraft in the event of BA going bust – to help ensure the company's long-term survival. "The trustees took the view that it is better to have a stronger BA," he explained. "Previously, the pension fund could call on this guarantee, now BA can." Shares in BA rose by 6% at one stage this morning, and were up 2.6% in afternoon trading at 135.6p.
BA said the £300m convertible bond, which is subject to a shareholder vote, was oversubscribed this morning. "We're very happy with the level of interest," said BA's chief financial officer, Keith Williams. BA has indicated that the bonds will be convertible into between 15% and 20% of its share capital in 2014. Convertible bonds dilutes existing investors' holdings less than a rights issue. They also incur a lower rate of interest than other types of borrowing. The scale of BA's recent losses and the state of the wider airline market has sparked speculation over its future. BA insists that it is taking action to remain competitive. One example cited by Walsh at BA's annual general meeting on Tuesday was the decision to pull business class seats out of its planes.
"Fewer business travellers will choose the premium cabins, and those who do will pay less," Walsh told shareholders. "Hanging on in there and just hoping for old high-roller times to return is the road to oblivion."
The airline faces a battle with unions over its plans to cut 3,700 jobs. Walsh pointed out that the airline has already reached deals with pilots and engineers, and said he was "solely focused" on finding agreement with other groups such as cabin crews. "Talks are ongoing. I expect they'll continue for a number of weeks and I remain very positive," said Walsh, who rejected the suggestion there was a risk of industrial action.
IMF warns pound could be at risk from uncertainty
The International Monetary Fund (IMF) has warned that Gordon Brown risks a run on the pound if he does not set out a clear path for reducing national debt. In a report published yesterday following a staff mission to Britain in May, the IMF said that a "credible plan" was needed to reverse the rapid deterioration of the public finances if confidence in the UK was to be upheld. "Market conditions suggest the UK has been getting the benefit of the doubt, both in the Government bond market and also the foreign exchange market," said Ajai Chopra, the IMF's mission chief for the UK. "This benefit of the doubt is not going to last forever and it's going to be important that the Government does not test the limit of the market's confidence.
"The authorities will need to move more aggressively in their fiscal consolidation plans and to be specific it will be important to set public debt on a firmly downward path faster than is envisaged in the 2009 Budget," he added. The IMF said the structural fiscal position was weak even before the financial crisis erupted and predicted gross debt is set to double over the next five years to 100pc of gross domestic product. George Osborne, the shadow chancellor, said: "The IMF could hardly have delivered a more damning verdict on the Brown years - and it vindicates Conservative warnings about the debt crisis."
Mr Chopra said that although that it was too soon to impose fiscal tightening, specific plans should be formed now so that they could be implemented once economic recovery was under way. The IMF predicts the UK economy will shrink by 4.2pc in 2009 before growing 0.2pc in 2010. The report added: "Should fiscal sustainability come into question, interest rates would rise despite monetary easing efforts, the ability of the Government to provide support to the financial sector would be severely limited and pressures on the currency could emerge."
Mr Chopra said the Government had been "ahead of the curve" by introducing bold policies, and said the authorities' focus must remain on strengthening the banking system, injecting more capital if necessary. He addedthe banking system was still too weak in its current state to support a strong recovery in the UK. Separately, the Prime Minister yesterday defended his response to the banking crisis and the decision to preserve the tripartite regulatory system where the Treasury, Financial Services Authority and the Bank of England each have a role. Mr Brown denied that Mervyn King, the Bank's Governor – who wanted the Bank to gain new powers – had become a "loose cannon" when asked by MPs. "The Governor does a good job and people recognise his talents, and that's why he was reappointed for a second term," Mr Brown said.
Kazakhstan central bank grapples with CDS headache
Astana, the capital of Kazakhstan, lies thousands of miles from London's trading rooms - let alone the political lobbyists in Washington. This summer, however, Grigori Marchenko, the Kazakh central bank governor, has reason to follow the US and UK debate about the future of credit derivatives with particular interest. By the end of this month, Kazakhstan is supposed to restructure two of its highest profile banks, BTA and Alliance, which have all but collapsed in recent months. This reorganisation would be emotive and challenging in any circumstances, given the complexity of Kazakhstan's domestic political scene. .
But the saga also has an element of international controversy because of the presence of credit derivatives. Back in the heady days of the credit boom, from 2004 to 2007, numerous western banks rushed to provide finance to Kazakh banks - and some, such as Morgan Stanley, also hedged their exposure using credit derivatives. That trade may have left some players with a net "short" position in the banks (meaning they stand to benefit if the company goes into default). What Mr Marchenko is trying to understand is how these incentives are affecting credit behaviour.
"This is a whole new ball game - I don't think anyone was prepared for what has happened here," says Mr Marchenko. "There is a new class of financial institutions now who are speculating that BTA [and others] go into a default . . . rather than in keeping the bank as a going concern. There is an underlying principle of restructuring that all investors should be treated equally. But what if everyone [in the creditor group] accelerated [the process of default]?" This question of "acceleration" is crucial because of the behaviour of some BTA creditors. This spring, when it became clear that BTA was hovering near collapse, the government tried to organise a restructuring. But before it was completed, Morgan Stanley and another large international creditor demanded repayment of their loans, which BTA refused to do.
Soon afterwards, Morgan Stanley asked a committee linked to the International Swaps and Derivatives Association in New York to rule whether CDS contracts linked to BTA could be activated. The ISDA committee ruled there was a default, ensuring that Morgan Stanley (and others) could duly claim on the CDS. Morgan Stanley has declined comment. But traders with good knowledge of the Western banks' market strategy believe that the foreign groups were mostly using CDS to protect themselves against potential losses on loans, not to short BTA. In practice it is impossible to tell the real motive because while the DTCC in New York collects some overall data on CDS trading - which suggests there are $700m contracts outstanding - the banks do not need to disclose who is short, or not. "The problem is that the CDS market is not transparent," says Mr Marchenko.
Thus far, the Kazakhs are not seeking to ban CDSs. "Abolishing [CDS contracts] might be a bit radical - it is easier to regulate CDSs than prohibit them entirely. They grow like mushrooms in the dark," says Mr Marchenko. The central banks wants to see "a middle-of-the-road approach - only those companies and institutions that own underlying securities should be allowed to buy CDS. There should be better disclosure and central clearing". Such calls are not limited to Kazakhstan. In the US, there is concern that credit derivatives might be creating perverse incentives, after the bankruptcy of some American groups. Western regulators are actively promoting measures to introduce more transparency and place CDS in a clearing house. Some US politicians also want to limit the use of these contracts to hedging, although this is a minority view.
Western bankers, for their part, retort that the CDS is simply a red herring in the case of the Kazakhs. They point out, irrespective of CDS, the state of Kazakh banks is pretty opaque. On paper, the government has set a deadline of the end of the month for restructuring the banks. However, this is proving "extremely complicated", says Michael Carter, chief executive of Visor Capital, a Kazakh investment bank. BTA, for example, has foreign debts of $9bn (more than half of all borrowing) - but it also has "assets throughout the CIS [Commonwealth of Independent States] that the government is slowly finding that it does not control", Mr Carter says. Several billion dollars of these assets have apparently vanished into a black hole - to the surprise of the Kazakh government and western creditors.
The government has now appointed Lovell, the law firm, to hunt for the missing assets. Goldman Sachs, which was acting as an adviser to the government, has resigned for reasons that - like much else - are unclear. Lazard Freres has replaced Goldman and is trying to organise a creditors' committee. "We believe there should be a market-based solution, and it should be resolved in an amicable way," Mr Marchenko says.
It is far from clear whether Lazard Freres will find a way to resolve these conflicting interests - or what the long-term impact will be. Last month, Nursultan Nazarbayev, Kazakhstan's president, told parliament that the Kazakh banking system had "failed the test". He called on local regulators to develop a new model for banks that would prevent them from borrowing too much from western banks in future. "The key point that everyone is forgetting is that [bankers] would not have lent as much money to Kazakhstan if they had not been able to hedge their exposure with CDS - there was just too much risk," says one western banker. "Now everyone fingers CDS. But these events also show why hedging is so important."